Startups: Don’t compete on “nimble” and “cash burn”.

Fifteen years ago I was sitting on a panel with senior executives of large enterprises. We were discussing how startups, with their limited resources, are competing against established, well-funded public enterprises. A Corporate R&D executive of a public company quipped:

Publicly traded companies usually can’t afford to lose money. Internet companies and startups can, at least for a while.

That’s interesting. And it’s wrong.

Competing on Cash Burn: The Myth of The Need to be Profitable as a Public Company

As of January 14, 2019, there are 741 Tech companies on NYSE and NASDAQ:

Net Income is a line-item on every public company’s reported Income Statement. Net Income is calculated under General Accepted Accounting Principles, or “GAAP.” EBITDA is the Net Income and adding the expenses (and returns) of interest, taxes, depreciation and amortization expenses back to it. EBITDA is not GAAP regulated and can (potentially) be quite fudged. Operating Income is an accounting figure that measures the amount of profit realized from a business’s operations, after deducting operating expenses such as wages, depreciation, and cost of goods sold (COGS). The Operating Margin is the Operating Income divided by Total Revenue.

There are, in fact, many public companies who are aggressively investing in growth and burn through cash, and they are doing that for a while now. When you raise your next $35m Series C round for your Enterprise Software startup that you think should last you 24 months, think about Splunk’s reported $140m of Free Cash Flow at a -$313m Net Income, with almost $1.9bn Cash or Cash Equivalents in the bank. So competing on cash burn might not be the smartest idea.

But How Long Can Public Companies Burn Cash?!

Answer 1: For as long as private investors keep pouring money into them, just like startups. In 2018, we saw about 51 investments into NASDAQ and NYSE noted public companies. 41 deals (79%) were PIPE deals — Private-Investment-in-Public-Equity –, 4 deals (8%) were secondary offerings of shares, 3 deals (6%) reverse mergers, and 2 deals (4%) Private Equity expansion or growth investments. Also, just like startups, public companies can take on new debt or refinance existing debt. Some companies such as Snap have a surprisingly low debt-to-equity ratio.

Answer 2: All public companies with negative net income are consciously deciding to re-invest earnings into growth or business transformation. And a lot of them have a surprising long runway. I use a back-of-the-envelope calculation I call the “CashIndex-100” and “CashIndex-85“:

  • Take last reported cash and cash equivalents; revenue; revenue growth; (negative) net income.
  • Linear forecast: Assuming exactly the same ratio of negative net income to revenue in the next years as well as the same revenue growth, how long could the company operate before their cash is depleted (and without taking any other actions)?

I found that a linear forecast is a conservative assumption for most public companies with negative net income. To adjust for a potential slowing in revenue growth, the CashIndex-85 assumes a year-over-year dampening of revenue growth by 15% — for example 100% growth in year one, then 85%, 72.25%, 61.41%, 52.20%, etc. When you keep the ratio of negative net income to revenue constant, a lower revenue growth implies less net income losses and thus a longer runway than the CashIndex-100.

Do not take the CashIndex number literally as the number of years a company can operate before running out of cash! (REALLY! DON’T!) I use the CashIndex only as an indicator for a relative assessment between several companies. A lower CashIndex than a peer indicates higher urgency to change spending behavior or raise more money. A higher CashIndex than a peer indicates the option to invest more in growth and business transformation activities.

There are a surprising number of public companies with a negative net income with a CashIndex-100 greater than 4.0!

Public NYSE and NASDAQ companies that reported a TTM negative net income, TTM revenue <$250m, but have a CashIndex-100 of 4.0 or greater (Source: PitchBook, as of 01/14/2019)
Public NYSE and NASDAQ companies that reported a TTM negative net income, TTM revenue of $250m to $1bn, but have a CashIndex-100 of 4.0 or greater (Source: PitchBook, as of 01/14/2019)
Public NYSE and NASDAQ companies that reported a TTM negative net income, TTM revenue greater than $1bn, but have a CashIndex-100 of 4.0 or greater (Source: PitchBook, as of 01/14/2019)

Palo Alto Networks, for example, reported $2.4bn TTM revenue at 71.64% gross margin and a 29.9% growth rate. They basically added over $550m new revenue in the last twelve month, with a strategy that made them end with a reported TTM -$122.2m net income … and still $1.78bn cash (and cash equivalents) in the bank. They can keep this up for a few years. And unless your startup is suddenly eating massively into their revenue (read: $50m+) or massively increases their customer acquisition cost, they might not care that much: About 35+ analysts estimate that they will end July 31st, 2019 with 2.8bn+ revenue, and July 31st, 2020 with 3.3bn+ revenue.

Next time you are thinking about being far more nimble and can redirect your precious Series B/C investment amounts much faster than any of the large public competitors you can be assured that there might be some other reasons at play as well — and that public companies always have options.

One thought on “Startups: Don’t compete on “nimble” and “cash burn”.

Thoughts? Opinions? Comments? Corrections?